Richard F. Syron's Speech at the Lehman Brothers Financial Services Conference on September 13, 2005

Prepared Remarks of Richard F. Syron
Chairman and CEO Freddie Mac

Lehman Brothers Financial Services Conference
New York, NY
September 13, 2005

Introduction

Before I begin, let me make sure I've shown you our standard slide on forward-looking statements. [Slide 1] Now, let me begin by saying thanks to you, Bruce, and thanks to Lehman for this opportunity to speak to you today about Freddie Mac.

I think many of you would agree with me in saying that the U.S. housing market is at the top of the national agenda. It was at the top before Hurricane Katrina and is now even more so.

In particular, as many analysts have noted, the upward trend of the economy in the recent past, has largely been fueled by continued strong housing activity. Although the housing market has prevailed thus far in the economic tug of war with higher oil prices, the net impact of these two opposing market forces on American consumers will contribute meaningfully to how the economy will look in 2006.

In the midst of these market developments, the management of Freddie Mac is staying focused on our key priorities: We have continued to generate economic value while managing the risks of our business and serving our housing mission.

Through the first half of 2005, looking at all of our metrics taken as a whole – GAAP, fair value, operating and risk management results – we have made very good progress on improving the business in ways that will both serve our housing mission and reward shareholders over the long term. Let me cover some of this with you in the next few minutes:

• First, we grew both the fair value of stockholders' equity and our regulatory capital surplus in the first half. Our focus is on generating long-term fair value returns, something I'll discuss in more detail.
  
• Second, we have continued to grow our market share within the GSE segment of the mortgage market. But perhaps even more importantly, we're taking steps to increase our share of the overall mortgage market.
  
• Third, we're taking a number of steps to respond to the catastrophic aftermath of Hurricane Katrina, including giving $10 million to the humanitarian recovery effort and providing mortgage payment relief to affected families and the lenders who service their loans. But at the same time, we are appropriately managing our credit exposures along with our financial counterparties in the insurance and servicing industries. More on that later.
  
• Finally, we're continuing to work hard to effect a constructive outcome on the legislative issue in Congress.

That's a lot of ground to cover in the next few minutes, so let me get right to it.

First half 2005 financial results

Taken as a whole, our financial results for the first half of 2005 were respectable, though by some measures, our results fell short of those that we would find acceptable or expect to achieve in the longer term. On the plus side, I'm pleased with the progress we are making towards becoming fully current and timely in our financial reporting. And we continue to show good results in a number of key areas: the growth in our business, the low levels of credit and interest rate risk we have maintained, as well as the increase in regulatory capital surplus and fair value that we generated.

But let's face it: The GAAP numbers we reported continue to reflect the substantial volatility in our income statement and balance sheet.

This volatility is caused by the application of GAAP accounting rules to the company's balance sheet, which results in three entirely different financial presentations for our mortgages, debt and the derivatives we use to manage our interest rate exposure. In contrast, we manage our business primarily by looking at fair value metrics, in which all of our assets, liabilities and derivatives are treated on a consistent basis, giving us what we believe is a more informed view of our long-term risks and economics.

To illustrate, let's look at [Slide 2], which compares the changes in our GAAP balance sheet stockholders' equity to the fair value of net assets over the past six quarters. The variation between GAAP stockholders' equity and fair value equity shown here is produced by the varying accounting presentations under GAAP.

Turning to these fair value results for the first two quarters of the year shown on this slide [Slide 3], the fair value of net assets attributable to common stockholders, rose to $27.4 billion at June 30, 2005. For the same period, the fair value of net assets attributable to common stockholders, before common dividends increased by $1.1 billion, as compared to an increase of $2.5 billion for the first six months of 2004.

The increase in fair value for the first six months of 2005 represents an annualized return on average fair value of common equity before capital transactions of approximately 8 percent, a figure that clearly fell short of our long-term expectations, due largely to a widening in option-adjusted mortgage-to-debt spreads. Looking past 2005, our long-term expectation is to generate returns in the low- to mid-teens on our average fair value of net assets attributable to common stockholders before capital transactions. As we've noted previously, you should expect to see us report substantial fluctuations from period to period in our fair value returns due primarily to market changes in mortgage-to-debt option-adjusted spreads and fair value changes associated with our guarantee fee business.

Average annualized fair value return over the past six quarters is 15%

Let me pause and briefly address these fair value returns, and how I think about them. This slide [Slide 4] shows our quarterly annualized return on average fair value of common equity before capital transactions for the last six quarters. As you can see, over that time period, the average return has been about 15 percent. This is significant for two reasons:

• First, we achieved this growth in fair value despite a net mark-to-market loss associated with widening in the mortgage-to-debt spread since year-end 2003.
  
• Second, during this period, we experienced less than 1.5 percent annualized growth in our retained portfolio.

The fact that we achieved this growth in fair value in an environment that saw below-trend portfolio growth, says something good about the strength of our franchise, and the durability of our long-term return prospects.

Ironically, as option-adjusted mortgage-to-debt spreads widen, this decreases the fair value of our existing portfolio while at the same time improving our opportunities to do new business. Conversely, when spreads tighten, the fair value of our existing assets increases, but new business opportunities become tougher for us. The quarterly fair value numbers we report rise and fall because they reflect the widening and tightening of these spreads. However, this ebbing and flowing of present value and future value changes washes out over the longer term on existing positions, while changing expected returns on new purchases.

We've gotten some questions on the low- to mid-teens fair value return guidance we gave on the August 31 earnings call, so let me explain a few of the key assumptions we used in coming up with that statement. In this guidance, we're communicating what we believe the basic earnings power of the company is over a long-term timeframe, using our current fair value of common equity as the point of departure, because fair value metrics come closest to reflecting our underlying economics.

• First, with respect to growth in business volumes, we used a range of assumptions. However, even our most optimistic assumption does not reflect growth either on our retained or guarantee volumes at a rate above the lower end of estimated growth in mortgage debt outstanding.
  
• Second, our base line assumption on the spreads we will earn on this business are consistent with those we are currently achieving, but assuming no benefit or detriment from a tightening or widening of mortgage-to–debt, option-adjusted spreads.
  
• Finally, as to our capital assumptions, we indicated on our earnings call that our guidance is based upon the current statutory requirement. Our guidance also takes into account the fact that we currently have capital significantly in excess of our statutory requirement. For this reason, our long-term guidance incorporates assumptions regarding the return of capital to shareholders over an intermediate time frame.

I know that capital management issues are a matter of great interest to many of you. As management, we recognize that our ultimate success depends upon our continued safe and sound operations, and our management of capital must be mindful of regulatory and rating agency requirements, the economic risks of our business and the potential for future income statement volatility. But, as we've said many times, we are keenly aware that this is your money. As we return to timely reporting, we would expect to return capital to shareholders at a rate that significantly exceeds our current payout ratio. This slide [Slide 5] shows that since 2000, we have increased our return of capital – and we are confident that we can continue doing so in the future.

We have a strong record of returning capital to shareholders

Operating Results and Risk Management

The second major area I'd like to address is our progress in advancing the baseline business and operations of the company, including a discussion of our current credit risk exposures.

Let's begin with how we are doing in returning our focus to our customers, which is an essential part of what this management team is trying to accomplish. One measure of customer focus is our market share, and this slide [Slide 6] illustrates that we have grown our market share to around 45 percent of the GSE securitization market through the first half.

However, we are not content to measure ourselves solely on our share of the GSE portion of the market – which has, in fact, been shrinking. Much of this is due to recent changes in the mix of products in the broader market, and some of those changes are likely to self-reverse. However, we can't sit back and hope that the mix of mortgage products will cycle back to the traditional, plain vanilla products. If you want to influence the market, you have to be in the market. Accordingly, we are expanding our capability to intermediate a broader range of mortgage credit exposures, similar to the way we currently manage and distribute a wide range of mortgage interest-rate risk. These enhanced capabilities will help us stay competitive in the evolving market while managing our credit and market risks with continued discipline.

Credit and interest-rate risks remain low

As we've reported for the first half, our current risk positions are very sound, with very low and acceptable levels of interest rate risk and credit risk. This slide [Slide 7] shows that our duration gap, at about 0 months, indicates extremely low levels of exposure to sudden changes in interest rates. The slide also shows that, while our total credit losses have remained relatively flat in the first half of 2005, our 90-day single family delinquencies have actually gone down from the levels experienced in the first half of 2004.

These results speak to the strength of Freddie Mac's credit risk management process. But they also underscore the strength of the U.S. housing market in the past few years. Even before Katrina, however, questions were being raised about the ability of the market to sustain this very long run of low credit losses. Through the summer, the story in the U.S. housing market was the continued growth in home prices and the increasing exposure of lenders and borrowers to new mortgage products – including interest-only and negative amortization types of instruments. During our earnings call, we provided you some information on our very limited exposure to these types of exotic mortgage products.

Our total single-family mortgage portfolio has relatively little exposure to new products

As this slide [Slide 8] shows, these products comprise only about 2 percent of our single-family mortgage portfolio. And, we also showed you a slide [Slide 9] that, through the first half, our average loan-to-value ratio of our portfolio, was extremely low, at around 57 percent.

Our core philosophy is pretty simple: If we have to trade some volume of business in the short term to avoid compromising our long-term discipline, we'll do it. We are convinced that's the right approach for our shareholders. And, I should add, it is the right approach on the mission side as well. Not least because, when we are faced with a possible credit risk issue – as we are now with Hurricane Katrina – we can respond from a position of enormous financial strength.

So let's talk about Katrina. We feel a responsibility – not only as a good corporate citizen, but in a unique way as a GSE, to look out for the best interests of the housing finance system. We are working closely with local governments and organizations to ensure that our $10 million donation helps re-build communities. We are providing mortgage payment relief to affected families and, equally important, we are providing short-term payment relief to mortgage servicers. These steps will allow families and lenders the breathing room to sort out all of the payment and paperwork issues while they're putting their lives back together.

Moreover, these temporary measures do not affect Freddie Mac's guarantee on our mortgage securities, and we will make all payments of principal and interest due to our PC holders on schedule. Rather, they underscore our capacity and willingness to step up and protect America's housing finance system when unforeseen events call for prompt action.

We also understand our responsibility to our shareholders, so let me give you some information regarding our credit exposures as a result of the storm. By way of background, hurricane damage is typically covered by property insurance, which we obviously require on all of our loans, and flood damage in the past has been largely covered by some combination of pre-existing federal insurance policies and federal disaster assistance.

It's too early for me to give you a precise number on how Katrina may affect our overall credit profile or our loss reserves. Our credit guarantee portfolio today stands at a little over $1.2 trillion. The mortgages within the FEMA disaster area covering a substantial portion of the states of Louisiana, Mississippi and Alabama, represent less than 1 percent of our overall credit guarantee portfolio. And the mortgages we guarantee in the three large parishes in the immediate New Orleans area where much of the worst flooding occurred represent about a quarter of that exposure.

Our experience to date in dealing with the aftermath of hurricanes and flooding is that these kinds of events – even very large ones, such as Hurricane Andrew in 1992 and the Mississippi River flooding in 1993 – have not materially affected the trend of our credit losses. Katrina differs from these two events because of sheer scale and because of the extent of displacement of homeowners that has resulted. How these real world losses translate into our financial results remains to be seen, but we are very well positioned to handle the outcome. In the meantime, we'll continue to do what we can to help homeowners recover and get back on track. It's the right thing to do both for our mission and for our shareholders.

Legislative Outlook

Let me conclude by addressing the issue of GSE regulatory reform. [Slide 10]

As you might guess, I'm not going to get into the business of predicting an outcome, or give a public play-by-play of our legislative situation and strategy. But you should know that we are clearly making our views and concerns known to the appropriate people, in the appropriate forums.

Again, Freddie Mac strongly supports the need for strengthened regulatory oversight. A world-class, independent regulator is the right way to ensure that the public, investors and Congress have full confidence in the GSEs and our continued ability to serve our mission. And we still believe this to be an achievable outcome.

That said, any regulatory reform must take into consideration the risks it poses for the housing sector – given that housing has become an essential pillar of the economy and an engine of economic growth. According to Wall Street research, housing-related activities have been responsible for 40 percent of the 2.3 million jobs added since the 2001 recession, and housing-related industries accounted for up to a third of the nation's economic growth over the four quarters that ended in March. Clearly, without these strong contributions from the housing sector, the American economy would have under-performed in the past several years.

And recent events such as the hurricane, the economic effects of high gas prices, and concerns about a real estate bubble, make it even more important that there not be any hasty or ill-considered changes to the GSEs.

So while Freddie Mac continues to be a strong supporter of regulatory reform and strengthened oversight, our ability to help keep the housing market robust should not be put at risk.

Conclusion

With that important point made, I'll wrap up. [Slide 11] When I first joined Freddie, I said that it would take three to five years to fully rebuild the company. Thus far, we have made good progress, but clearly we have a lot more work to do.

As a financial services company, our success will ultimately be determined by the quality of our management team and the growth and strength of our capital position. After nearly two years of building this team, I am confident that our new leadership, and the new senior managers we have added since mid-2003, are the very best people for the jobs. As Bill Belichick has shown, organizations succeed through the efforts of the team, not individuals.

In sum, our capital is stronger than it has ever been, and we continue to grow it through our core operations, world-class risk management practices, and a focus on building lasting value for our shareholders that will hold up over the long term.

That's a good note to end on. And now I'd be happy to answer your questions.